He is the leading light for investors worldwide and every word he says is scrutinised and studied by throngs of budding investors. There are endless articles, videos and newsreels out there featuring the life of Warren Buffett and Berkshire Hathaway. It has reached a point where there are listicles citing unverified quotes from Buffett being shared by millions on Facebook. Everyone wants to be a billionaire investor, yet there is only one Warren Buffett and only a handful of billionaire investors that are worth at most half of Buffett’s wealth. This is a sobering shot of reality, buckle up.
It’s great to be motivated by Buffett’s success, but how many out there have the discipline to actually implement good habits and stay within their circle of competence for decades? Moreover, Buffett’s successes in the past can’t realistically be repeated today as the dynamic has shifted permanently.
A majority of investors assume Warren Buffett got rich by investing in great companies at fair prices i.e. Coca-Cola, American Express and Wells Fargo. But can a retail investor be made a billionaire by investing in such companies alone? Buffett spent years (1988 – 1989) accumulating Coke stock for approximately a billion dollars. Even if you can find such an enticing company today, where do you find the billion dollars to invest?
The key is to look at Buffett’s early history as a capital allocator.
1. Other people’s money
The key to Buffett’s wealth and almost every other billionaire is leverage, and for Buffett, he’s an expert at using OPM (other people’s money).
Buffett once famously said that when you buy shares of a company, you’re essentially a business owner and you should watch it as if it were your own. Its earnings and cash technically belong to you. But now the crucial difference lies in the often-omitted detail of ownership – Buffett often buys the entire company for himself, or a substantial shareholding of the company, you can’t.
Back in the 50s, Buffett set up the Buffett Partnership, which was essentially a long-only hedge fund (though the term wasn’t widely used at the time). He funded the Buffett Partnership with his own savings and the investments of other associates. Using this structure, he then went out to buy small undervalued companies with which he could take economic control of. Buffett called them “work-outs” where corporate action was required for the company to unlock value; he was essentially an activist investor.
Value investing as a retail investor today versus value investing Buffett-style circa 1958 is different: the company you believe to be undervalued would require the management and/or the market to act on its cheapness to fully value the company, whilst Buffett would simply buy a majority stake and persuade the management to make the changes. A retail investor can only hope for an activist intervention that’s in his favour, but that’s a lousy investment thesis to begin with.
Imagine buying Apple stock, their cash hoard of US$249 billion is technically yours, but you own only 0.0000001% of the shareholding. You can’t really do anything with that cash, you certainly can’t cajole the management into giving it back to shareholders (incurring a 35% withholding tax) as you have close to no voice. Carl Icahn managed to force Apple to pay a dividend, but he had to invest more than a billion and use his fame to force management into acting in his favour, a feat that normal retail investors can’t achieve.
Buffett then dissolved Buffett Partnership and bought out the ailing Berkshire Hathaway company, a process that took years of accumulating its stock in the early 1960s. By gaining control of the textile company, he used the cash in that company to fund his investment in National Indemnity Company in 1967. This is a classic example of Buffett using OPM to purchase Berkshire, then using the target company’s cash holdings to acquire another company.
As retail investors, is it realistic that we can go and buy out an entire company and use its cash to acquire others? And that’s assuming that the management will be friendly to a takeover. If you can clear this first hurdle – meaning that you can gather a group of friends or family to co-invest in your fund to buy out an entire company, your chances of emulating Buffett just shot higher.
Following National Indemnity, Buffett then bought GEICO, Nebraska Furniture Mart and numerous other firms whole, using their cash holdings and swallowing others whole to grow. This is how he turned capital allocation into an art form that till today, many that have tried to copy his methods have fallen short in achieving the same magnitude of success.
2. Capital allocation
Buffett’s perspective on cash and leverage can be understood by judging how he invests and rewards shareholders of Berkshire. Berkshire has famously never paid a single dividend, but most of its investments do. He has railed against paying dividends as he believes that by reinvesting every single cent into his businesses, acquiring others or buying back shares when Berkshire dips below a certain price to book value, it gives shareholders a greater, tax-efficient return on investment. This is true as many early Berkshire investors have gotten very rich by simply holding on to Berkshire shares.
There are only a small handful of companies out there (called “Baby Berkshires”) that have been successful at not paying dividends and seeing their stock price compound wondrously over a long period of time. As a retail investor, finding such a company is tough as you must have absolute faith in the management. Great capital allocators are extremely rare in the corporate world. One such company loosely considered to be a baby Berkshire would be Danaher.
Simply buying dividend-paying shares may not even cut it especially if the company’s reinvestment opportunities give far greater economic benefit than paying out cash to shareholders. Then again, as a small investor, what can you do about it? Shout at management at the AGM? It’s one of the biggest questions investors big and small ask themselves – what kind of reinvestment opportunities would their portfolio or prospective companies have going forward? Do you trust the management to allocate your capital wisely or would you rather they paid the profits back to you via dividends as you believe you’re the better capital allocator?
3. Economic growth
An oft-disregarded fact that aided Buffett’s ascendency is the unparalleled growth of the US economy from the 50s to the 90s. In a slow-growing, mature or stagnant economy, it’s much tougher to achieve outsized returns at an annual rate of 20% compounded for decades.
Size counts as well – the U.S. economy grew to be the largest economy in the world, the runway for growth is huge for American companies operating within the States itself without having to venture overseas. One can’t realistically expect a Singaporean firm that only sells its services/products in Singapore to make one a billionaire now that Singapore’s economy has matured and the runway for growth highly limited.
Whenever you try to forecast economic growth for a certain country, simply ask yourself this: “What is the basis for my belief that Country X’s economy/stock market will grow X% over the long run?” Question the validity of your assumption.
Buffett has repeatedly said that he owes his wealth to him being born at the right time, and at the right place and this is often left out in many listicles about him.
4. Market inefficiencies
Markets today are way more efficient than the markets during Buffett’s younger years. There was no Bloomberg, Microsoft Office (Excel in particular), Capital IQ nor the Internet. Most analyses were literally done on paper with a calculator and pen. Public information was available, but it was scarce as there was no Google to parse information and keep it readily available. On the flipside, global markets have never been more readily accessible today, you can invest almost anywhere in the world without even stepping out of your room. This makes life easier (or tougher) for the budding value investor as there’s no excuse now to miss on any opportunities overseas.
In the 50s, Buffett’s partnerships were perhaps one of the few existing hedge funds in the world. Now, there are tens of thousands of funds using highly complex (or simple) strategies to hunt inefficiencies in the markets. We can easily find a 10-K on Apple thanks to Google and can analyse its financial statements using Excel, we can also use various free stock screeners to screen for “value” plays. How many million more people out there can do that versus the 50s? The market has gotten more efficient with the ease of access.
Buffett himself no longer invests in public equities as aggressively as before as Berkshire has grown too large to have a small company move its needle. He now hunts the big game – buying out companies private-equity style to expand the Berkshire empire.
5. Compounding habits
Another key to Buffett’s success is behavioural. Compounding doesn’t just work for interest on money, but on other factors like habits.
Buffett has always been interested in money since young, he sold chewing gum and Coca-Cola drinks when he was just six, he then bought his first stock at the age of 11 – purchasing Cities Service at $38 a share, selling it at $40. He then had to watch it painfully rise to over $200.
At the age of 13, he filed his first tax return. Age 15, he delivered Washington Post newspapers and at 17, started a pinball machine business. By the time he was 27, he had studied under and worked for Benjamin Graham and started five partnerships investing his and his clients’ monies.
This is the power of compounding – his voracious appetite for making money since he was six had snowballed into making him one of the richest men in the world. The average retail investor does not have the same habits and reading endless articles on how to change one’s habit wouldn’t help an iota if one doesn’t have the discipline to stick with it for decades. His habits seem easy at first thought, like reading, but imagine doing that for maybe just one month, few would be able to sustain the intensity.
The fifth perspective
Be realistic in your goals. Everyone can read about Buffett, and anyone can use a stock screener, but only a handful can make outsized returns over a long period of time. Know your circle of competence, and acknowledge that you have a close-to-impossible chance of becoming as rich as Buffett to be humble in your investing strategy.
Know what circumstances surround you and certain facts that can’t be changed, acknowledge them and keep your expectations to a realistic level. Reading articles or news snippets on Buffett is fine, but do not turn it into an obsession where you end up being unhappy having failed to reach your lofty goals despite “following the advice” of the author of that article – including me.